In Cadrecha v. United States, No. 11-152 (Apr. 2, 2012), the Court of Federal Claims ruled that the taxpayers could not escape the clutches of the statute of limitations, even though the failure to file a timely lawsuit was largely attributable to contradictory and confusing IRS communications. The taxpayers have now appealed, hoping that the Federal Circuit will be more sympathetic.

The Court of Federal Claims acknowledged that the result was “harsh” on these facts. The taxpayers filed a timely amended return in March 2007, styled as a protective claim for refund, on the theory that a recent Court of Federal Claims decision (Fisher) entitled the taxpayers to a refund of gains reported from the sale of stock received as a result of an insurance company demutualization. (That decision was affirmed by the Federal Circuit in October 2009). After the three-year statute of limitations had expired, the IRS responded by asking for more “supporting information” and invited the taxpayers to file another claim identifying the court case on which it relied. The taxpayers replied to this letter in May 2007, identifying the case.

The IRS then sent a couple of letters indicating that it needed more time to respond. Thereafter, in August 2007, it sent a notice disallowing the claim on the ground that it was untimely. This disallowance was patently erroneous, as the IRS apparently overlooked the March 2007 amended return and instead treated the May 2007 supplementary letter as if it were the original refund claim. The letter disallowing the claim invited the taxpayers to appeal the disallowance to the IRS Appeals Office and also stated that the taxpayers had two years to file a refund suit.

The taxpayers immediately responded with a letter pointing out that the IRS had erred in ignoring the March 2007 filing. There ensued a succession of communications from the IRS — at least seven letters plus some oral conversations — in which the IRS reported various transfers to different IRS offices and that it needed more time to research the issue. By the time the taxpayer lost patience with this process and filed suit in the Court of Federal Claims, more than two years had elapsed since the disallowance letter was sent. The court therefore dismissed the suit as untimely — even though there was no question that the IRS’s ground for disallowance (an allegedly untimely refund claim) was erroneous and that the taxpayer’s position was correct on the merits under Federal Circuit precedent. The court acknowledged that this result was “harsh” because the untimeliness was, in large part, attributable to the IRS’s own behavior; the court found that “[a]s a result, to some degree, of the IRS’s actions, plaintiffs may have come to believe that the IRS was continuing to analyze their refund claim and that the IRS was in the process of reconsidering the notice of disallowance.”

The court held, however, that there was no legal basis for excusing the taxpayers’ failure to file suit within the two-year limitations period. The taxpayers relied upon cases that excused apparent statute of limitations problems on the ground that the IRS had orally withdrawn a notice of disallowance. The court found those cases distinguishable, observing that neither the notice of disallowance nor the timeliness issue was mentioned in any of the IRS correspondence — though that correspondence certainly suggested that the taxpayers’ claim was still under active consideration at the IRS. The court then added that the law does not permit equitable tolling of the statute of limitations and therefore, if the notice was not withdrawn, it made no difference “if the actions of the IRS misled or confused the taxpayer.”

Long-time readers of the blog may recall our coverage of the Federal Circuit’s stumbles through TEFRA in the Bush litigation, where a panel issued a surprising decision finding that a notice of deficiency was required to make what was previously understood as a mere TEFRA computational adjustment, but that the IRS’s failure to issue the notice was harmless error. Both sides cried foul, and the en banc court overturned the panel’s decision. The Supreme Court this morning today denied the taxpayers’ petition for certiorari, meaning that the case has reached the end of the line, which turns out to be pretty much where the Court of Federal Claims put the case in the first place.

The Supreme Court last week ruled 5-4 in favor of the taxpayer in Home Concrete, thus putting an end to the long-running saga of the Intermountain litigation on which we have been reporting for the past 18 months. The opinion was authored by Justice Breyer and joined in full by three other Justices, but Justice Scalia joined only in part. The result is a definitive resolution of the specific tax issue – the six-year statute of limitations does not apply to an overstatement of basis. But the Court’s decision provides a much less definitive resolution of the broader administrative law issues implicated in the case.

As foreshadowed by the oral argument (see our previous report here), the tax issue turned on the continuing vitality of the Court’s decision in The Colony, Inc. v. Commissioner, 357 U.S. 28 (1958). To recap, the Court held in Colony that the “omits from gross income” language in the 1939 Code did not encompass situations where the return understates gross income because of an overstatement of basis, and hence the extended six-year statute of limitations did not apply in those situations. The government argued that Colony did not control the interpretation of the same language in current section 6501(e) of the 1954 Code, because changes elsewhere in that section suggested that Congress might have intended a different result in the 1954 Code.

The administrative law issues came into play because, after two courts of appeals had ruled that Colony controlled the interpretation of the 1954 Code, the government tried an end run around that precedent. Treasury issued regulations interpreting the “omits from gross income” language in the 1954 Code as including overstatements of basis, thus bringing those situations within the six-year statute of limitations. Under National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005), the government argued, an agency is empowered to issue regulations that define a statute differently than an existing court decision, so long as the court decision did not declare the statutory language unambiguous. Because the Colony opinion had indicated that the 1939 Code language standing alone was “not unambiguous,” the government argued that Treasury’s new regulations were entitled to Chevron deference, which would supplant any precedential effect that Colony would otherwise have on the interpretation of the 1954 Code provision.

The Court’s Opinion

Justice Breyer wrote the opinion for the Court, joined in full by Chief Justice Roberts and Justices Alito and Thomas. Justice Scalia joined Justice Breyer’s analysis of the statute, but departed from his analysis of the administrative law issues.

The opinion dealt straightforwardly with the basic tax issue. First, the Court emphasized that the critical “omits from gross income” language in the current statute is identical to the 1939 Code language construed in Colony, and it recounted the Colony Court’s reasoning that led it to conclude that the language does not encompass overstatements of basis. Colony is determinative, the Court held, because it “would be difficult, perhaps impossible, to give the same language here a different interpretation without effectively overruling Colony, a course of action that basic principles of stare decisis wisely counsel us not to take.” With respect to the statutory changes made elsewhere in section 6501(e), the Court concluded that “these points are too fragile to bear the significant argumentative weight the Government seeks to place upon them.” The Court addressed each of these changes and concluded that none called for a different interpretation of the key language (and that one of the government’s arguments was “like hoping that a new batboy will change the outcome of the World Series”).

The Court then turned to the administrative law issues, reciting the government’s position that, under Brand X, the new regulations were owed deference despite the Court’s prior construction of the language in Colony. The opinion first responded to that position with a two-sentence subsection: “We do not accept this argument. In our view, Colony has already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency.”

Standing alone, that was not much of a response to the government’s Brand X argument, because Brand X said that the agency can adopt a construction different from that provided in a prior court decision so long as the statute was ambiguous. These two sentences were enough for Justice Scalia, however, and he ended his agreement with Justice Breyer’s opinion at this point. In a separate concurring opinion, Justice Scalia explained that he is adhering to the view expressed in his dissent in Brand X that an agency cannot issue regulations reinterpreting statutory language that has been definitively construed by a court.

With the other Justices in the majority not feeling free to ignore Brand X, Justice Breyer’s opinion (now a plurality opinion) then proceeded to explain why Brand X did not require a ruling for the government. According to the plurality, Brand X should be given a more nuanced reading than that urged by the government, one that looks to whether a prior judicial decision found a statute to be “unambiguous” in the sense that the court concluded that Congress intended to leave “‘no gap for the agency to fill’ and thus ‘no room for agency discretion.’” Under Chevron jurisprudence, the opinion continued, unambiguous statutory language provides a “clear sign” that Congress did not delegate gap-filling authority to an agency, while ambiguous language provides “a presumptive indication that Congress did delegate that gap-filling authority.” That presumption is not conclusive, however, and thus this reading of Brand X leaves room for a court to conclude that a judicial interpretation of ambiguous statutory language can foreclose an agency from issuing a contrary regulatory interpretation. In support of that proposition, the plurality quoted footnote 9 of Chevron, which states that “[i]f a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law and must be given effect.”

The plurality then ruled that the Court in Colony had concluded that Congress had definitively resolved the legal issue and left no gap to be filled by a regulatory interpretation. Given its analysis of the scope of Brand X, the plurality explained that the Colony Court’s statement (26 years before Chevron) that the statutory language was not “unambiguous” did not necessarily leave room for the agency to act. Rather, the Colony Court’s opinion as a whole – notably, its view that the taxpayer had the better interpretation of the statutory language and had additional support from the legislative history – showed that the Court believed that Congress had not “left a gap to fill.” Therefore, “the Government’s gap-filling regulation cannot change Colony’s interpretation of the statute,” and the Court today is obliged by stare decisis to follow it.

The Concurring and Dissenting Opinions

Justice Kennedy’s dissent, joined by Justices Ginsburg, Sotomayor, and Kagan, reached a different conclusion on the basic tax dispute. The dissent looked at the statutory changes made in the 1954 Code and concluded that they are “meaningful” and “strongly favor” the conclusion that the “omits from gross income” language in the 1954 Code should not be read the way the Colony Court read that same language in the 1939 Code. Given that view, the administrative law issue – and the resolution of the case – became easy. The dissent stated that the Treasury regulations are operating on a blank slate, construing a statute different from the one construed in Colony, and therefore they are owed Chevron deference without the need to rely on Brand X at all.

Justice Scalia’s concurring opinion declared a pox on both houses. He was extremely critical of the plurality’s approach, accusing it of “revising yet again the meaning of Chevron . . . in a direction that will create confusion and uncertainty.” He also criticized the dissent for praising the idea of a “continuing dialogue among the three branches of Government on questions of statutory interpretation,” when the right approach should be to say that “Congress prescribes and we obey.” Justice Scalia concluded: “Rather than making our judicial-review jurisprudence curiouser and curiouser, the Court should abandon the opinion that produces these contortions, Brand X. I join the judgment announced by the Court because it is indisputable that Colony resolved the construction of the statutory language at issue here, and that construction must therefore control.”

What Does It Mean?

The Home Concrete decision provides a clear resolution of the specific tax issue. The six-year statute of limitations does not apply to overstatements of basis. The multitude of cases pending administratively and in the courts that involve this issue will now be dismissed as untimely, leaving the IRS unable to recover what it estimated as close to $1 billion in unpaid taxes.

Indeed, in a series of orders issued on April 30, the Court has already cleared its docket of the other Intermountain-type cases that had been decided in the courts of appeals and kept alive by filing petitions for certiorari. In Burks and the other Fifth Circuit cases in which the taxpayers had prevailed, the Court simply denied certiorari, making the taxpayers’ victory final. For the certiorari petitions filed from courts of appeals that had sided with the government, such as Grapevine (Federal Circuit), Beard (Seventh Circuit), Salman Ranch (Tenth Circuit), and Intermountain and UTAM (D.C. Circuit), the Court granted the petitions and immediately vacated the court of appeals decisions and remanded the cases to the courts of appeals for reconsideration. Now constrained by Home Concrete, those courts will enter judgments in favor of the taxpayers in due course.

Notably, although the retroactive nature of the Treasury regulations was a significant point of contention in the litigation, retroactivity did not play a role in the final resolution. The Court held that Colony is controlling and leaves no room for the agency to construe the “omits from gross income” language differently. Thus, Treasury does not have the ability to use its regulatory authority to extend the six-year statute to overstatements of basis even prospectively. Any such extension will have to come from Congress.

The effect of the decision on administrative law generally is considerably more muddled. First, a couple of observations on what the Court did not do. It did not signal any retreat from Mayo. Treasury regulations addressed to tax issues will continue to be judged under the same Chevron deference principles that apply to regulations issued by other agencies. Furthermore, as noted above, the Court did not rely on the retroactive aspect of the regulations. Thus, the decision does not provide guidance one way or another on the extent to which Treasury is constrained in its ability to apply regulations to earlier tax years.

What the Court did do, however, is to weaken the authority of Brand X. Under the reasoning of Justice Breyer’s plurality opinion, courts are now free to decline to defer to a regulatory interpretation that construes ambiguous statutory language – if the court concludes that a prior court decision, using “traditional tools of statutory construction” that go beyond the text, determined that Congress intended to resolve the issue rather than leave a gap for the agency to fill. Although there were only four votes for that proposition, Justice Scalia’s approach would lead him to agree with such a result just as he did in Home Concrete, so lower courts may treat the plurality opinion as controlling. There is, however, room for debate about the impact of the Home Concrete approach. Justice Breyer’s opinion emphasizes the fact that Colony was decided long before Chevron, and lower courts may disagree regarding its impact when the court decision at issue is post-Chevron and, in particular, post-Brand X. At a minimum, the Home Concrete decision should make agencies less confident in their ability to use regulations to overturn judicial interpretations of statutes and should give taxpayers more ammunition to challenge such regulations if necessary.

Interestingly, Justice Breyer’s approach, and in particular his invocation of Chevron’s footnote 9 reference to “traditional tools of statutory construction,” was previewed in the argument in the Federal Circuit in the Grapevine case. As we reported at the time, that argument involved considerable discussion of whether the determination of “ambiguous” at Chevron step 1 must be based entirely on the statutory text, as Brand X suggests, or can be based on other “traditional tools of statutory construction,” as Chevron footnote 9 declares. In its decision, the Federal Circuit stuck to the statutory text and ruled for the government.

Justice Breyer’s opinion, however, supports the proposition that Chevron step 1 analysis can look beyond the statutory text. If that portion of Justice Breyer’s opinion had commanded a majority, it would be extremely significant because it would justify looking beyond the statutory text not only in assessing the impact of Brand X when there is a court decision on the books, but also in considering a Chevron deference argument in the first instance. A court could decide, under the approach suggested by Justice Breyer, that a statute whose text standing alone is ambiguous nonetheless leaves no room for agency interpretation – if other tools of statutory construction show that Congress intended to resolve the issue rather than leaving a gap for the agency. On this point, however, the plurality opinion cannot be treated as controlling because Justice Scalia would surely look askance at a decision that used legislative history to find a lack of ambiguity at Chevron Step 1. By the same token, the dissenters had no occasion to address this point, so we do not know if any of them would have agreed with Justice Breyer’s approach. For now, it is fair to say that Justice Breyer has heightened the visibility and potential importance of Chevron footnote 9, but that Home Concrete alone probably will not yield a significant change in how courts approach Chevron step 1.

In sum, Home Concrete may be a bit of a disappointment to those observers who thought that the decision would bring great clarity to the administrative law issues presented. In that respect, it joins a long list of administrative law cases that reach the Supreme Court and seem to yield as many questions as answers. But for the taxpayers with millions of dollars riding on the difference between a three-year and six-year statute of limitations, the decision is not disappointing at all. It is a huge victory.

The taxpayers in Bergmann v. Commissioner are appealing an adverse Tax Court decision, 137 T.C. No. 10, holding that they failed to timely file a qualified amended return for 2001 and thus are liable for the 20-percent accuracy related penalty. The taxpayers participated in a listed transaction promoted by KPMG, known as the Short Option Strategy. In 2004, two years after the IRS issued a summons to KPMG specifically identifying the Short Option Strategy transaction, the Bergmanns filed an amended return disclaiming the tax benefits of the transaction. The case concerns the interpretation of Treas. Reg. § 1.6664-2(c)(3)(ii) (2004), which establishes rules on the timing of filing a qualified amended return for undisclosed listed transactions. If an amended return is filed before certain terminating events, additional tax reported on the amended return will be treated as if it were reported on the original return. Under the “promoter provision,” the amended return must be filed before the IRS first contacts a person concerning liability under section 6700 (a promoter investigation). The Tax Court rejected the taxpayers’ argument that the IRS must establish that the target of the promoter investigation is in fact liable for a promoter penalty. The Tax Court also held that, in investigating the promoter, the IRS need only identify the “type” of transaction in which the taxpayer engaged, not the specific transaction or the identity of the taxpayer.

In 2000-2001, taxpayer Jeffrey Bergmann was a tax partner in KPMG’s Stratecon Group, which the Tax Court characterizes as “focused on designing, promoting and implementing aggressive tax planning strategies for high-net-worth individuals.” In tax years 2000 and 2001, Bergmann entered into a “Short Option Strategy” transaction promoted by fellow KPMG partner Jeffrey Greenberg. This transaction was identified by the IRS as an abusive tax shelter in Notice 2000-44, 2000-2 C.B. 255 (transactions generating losses by artificially inflating basis). The taxpayers (Bergmann and his wife) claimed losses for the 2000 and 2001 Short Option Strategy transactions on their 2001 return, but filed an amended return in March 2004 removing the losses attributable to the transactions and paying approximately $200,000 in additional tax. The IRS treated the qualified amended return as untimely and assessed accuracy-related penalties.

Under Treas. Reg. § 1.6664-2(c)(3)(ii), as in effect when the Bermanns filed their amended return, the time to file a qualified amended return terminates when the IRS first contacts a person “concerning” liability under section 6700 (a promoter investigation) for an “activity” with respect to which the taxpayer claimed a tax benefit. The IRS served KPMG with two summonses in March 2002, one of which was specifically targeted at KPMG’s involvement in promoting transactions covered by Notice 2000-44. Attempting to disassociate their transaction from those that were the subject of the KPMG investigation, the taxpayers argued that Greenberg acted in his individual capacity in advising them, not as an agent of KPMG. The Tax Court rejected this argument, concluding that the transactions in which the taxpayers engaged were within the scope of Greenberg’s responsibilities as a KPMG partner and also concluding that KPMG had not limited Greenberg’s authority to engage in Notice 2000-44 transactions with other KPMG partners, including Bergmann. The Tax Court also rejected the taxpayers’ argument that the promoter investigation must specifically identify the “activity” that gave rise to the tax benefit. The Tax Court held that the summons need only refer to the “type” of transaction in which the taxpayer participated. The court found that the March 2002 summons met this requirement because it specifically identified the transaction as the same or substantially similar to the transaction identified in Notice 2000-44.

The Tax Court noted that disclosure of the transaction after the Notice 2000-44 summons was served on KPMG would not have been voluntary. The Tax Court explained that the purpose of the promoter provision is to encourage taxpayers to voluntarily disclose abusive tax shelters. That purpose is effectuated by terminating the period to file a qualified amended return when disclosure would no longer be voluntary.

The Tax Court addressed a second issue as well. At first glance, the taxpayers appeared to be subject to the 40% gross overvaluation penalty because the scheme depended on what was found to be an artificially inflated based. They argued, however, that the tax underpayment was not “attributable to” the overvaluation because the Commissioner contended (and the taxpayers eventually conceded) that the entire transaction should be disallowed for lack of economic substance, thereby making the valuation irrelevant. The Tax Court noted that this type of bootstrapping argument has been rejected by several circuits, which have held that the 40% penalty applies when overvaluation is intertwined with a tax avoidance scheme, but that Ninth Circuit precedent has accepted the argument. Keller v. Commissioner, 556 F.3d 1056. Accordingly, the Tax Court rejected the IRS’s attempt to impose a 40% penalty, and the taxpayers were assessed only the standard 20% accuracy-related penalty. The IRS has not appealed this issue.

The taxpayers’ opening brief is due on May 16. The case is docketed in the Ninth Circuit as No. 12-70259.

About Miller & Chevalier’s Tax Appellate Blog

Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.